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A Good ETF: PowerShares Lux Nanotech

When PowerShares Lux Nanotech ETF (AMEX: PXN) made its debut in October 2005, I was not wild about it. At the time, I felt the exchange-traded fund excluded some legitimate nanotechnology companies, while giving too much weight to some questionable ones.

Since then, the fund has rectified some of these shortcomings by adding companies like Intel (Nasdaq: INTC) and Arrowhead Research (Nasdaq: ARWR) , while reducing the percentage it holds in some riskier stocks.

This combination of factors has caused me to reassess my opinion, and although I don't believe it is going to be the best ETF for 2007, I do believe it will do well. My opinion is a bit stronger than that of our Motley Fool CAPS community, which has pinned a lukewarm two-star rating on the fund.

A good, solid balanceOne of the strengths of this ETF, as with most ETFs, is its diversity. Nanotechnology, however, isn't your typical field. It is a common mistake to think of it as an industry. It isn't. Nanotechnology is more of a general-purpose technology, like electricity or the Internet. Because of this, I have always encouraged investors to think of nanotech's potential less from the perspective of what it is and more from the perspective of what it will allow existing businesses to do.

Nanotech is going to play a major role in health care, information technology, manufacturing, materials science, and energy. And PowerShares Lux Nanotech ETF has nicely distributed its holdings across companies that will serve these various markets.

At the present time, the fund has 28% of its holdings in health-care-related companies, 29% in information technology, 26% in materials, and 9% in industrial applications. The remaining percentages are rather hard to classify because they contain companies such as Motley Fool Rule Breakers recommendation Harris & Harris (Nasdaq: TINY) , which, as a publicly traded venture capital firm specializing in nanotechnology-related investments, is itself diversified across a range of industrial sectors.

Likely to be volatileOne of the things that makes the PowerShares Lux Nanotech ETF hard to characterize is that its greatest weaknesses are also likely to be its greatest strengths. In particular, the fund has two attributes that will make it more volatile than your typical ETF.

The first is the general makeup of the fund. Currently, 67% of its holdings are categorized as small caps, 8% as mid caps, and just 25% as large caps. Because nanotechnology is a relatively new and emerging field, it is only natural that most of the funds' holdings will be small-cap companies.

But, as I have written before, many of its large holdings -- companies such as 3M (NYSE: MMM) , General Electric (NYSE: GE) , and IBM (NYSE: IBM) -- are heavily involved in nanotechnology research and development, and a strong case could be made that they deserve to make up a larger percentage of the fund. However, I also understand that they are not nanotechnology "pure plays," because they are involved in so much more.

This argument aside, the effect of this heavy emphasis on small caps is that the fund is likely to experience more volatility than your typical ETF. For instance, if a core holding such as NVE (Nasdaq: NVEC) experiences a nice run-up, as it has in the past few months, it can be enough to noticeably move the fund. The downside is that when a company loses half its value -- which is not uncommon with smaller nanotech stocks -- it can have the opposite effect.

The second risk is more general in nature. Nanotechnology has benefited from unjustified hype in the past, and it is possible that it could again in the future. This will be especially likely if there is some major new nanotechnology breakthrough in the war on cancer, or a development in carbon nanotube technology that could help usher in an era of clean, affordable solar energy. A prime beneficiary of this positive news could be the nanotech ETF.

The flip side of this coin is that the entire field can also be adversely affected if nanotech gets a bad rap. Serious questions remain about the health and environmental risks associated with new nanomaterials and nanoparticles. Should any of these nanoparticles be found to be harmful, the public perception of nanotechnology could plummet and, whether it is warranted or not, this ETF could bear the brunt of that backlash.

Foolish final wordThe bottom line, of course, is that like so many new technologies, nanotechnology is a double-edged sword. It has great potential, but it also has risks -- mostly in the form of unanswered questions.

And that is why I have changed my tune on the PowerShares Lux Nanotech ETF. It isn't perfect, but neither am I. I can quibble with its selection of individual stocks or its balance between small-cap and large-cap stocks, but short of having a crystal ball, there is no perfect answer.

I like nanotechnology as an investment play, and if you do too, I believe this ETF does a good job of giving investors a healthy exposure to nanotechnology's potential at a relatively low cost. (The fund has an annual expense ratio of 0.73%.)

To my mind, this ETF is like a good all-terrain vehicle. Nanotech is likely to be a wild and exciting ride for the next few years, and this fund, while it can't entirely protect investors from all the bumps and bruises the ride might inflict, should allow them to experience the excitement of nanotech investing without having to deal with all the obstacles of investing in individual nanotech stocks.

Harris & Harris is a Rule Breakers pick. To see which other blockbusters-to-be have caught the attention of the Rule Breakers team, take a 30-day free trial of the service. Intel and 3M are Inside Value recommendations.

Fool contributor Jack Uldrich is the author of two books on nanotechnology, including Investing in Nanotechnology: Think Small, Win Big. He owns stock in Harris & Harris, GE, and Intel. The Fool has a strict disclosure policy.

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